04 Mar 2024 3 min read

Introducing our capital market assumptions framework

By Tim Armitage , Martin Dietz

Photographs are a wonderful way of preserving the past, allowing us to delve into our memories to relive special moments. However, our CAMERA (Capital Market Expected Return Assumptions) allows us to take a different type of snapshot – one of the future.


The following is an extract from our Q1 Asset Allocation outlook.

Underpinning every decision we make on behalf of our clients is a series of expectations – based in part on our experience of the past – of how the future is likely to unfold. Making decisions about the medium- to long-term future can be especially challenging, which is why it is important to have a robust framework in place.

Here we introduce CAMERA, our capital market assumptions framework, bringing together our valuations-based medium-term asset-class return expectations and our long-term risk-based equilibrium model.

Designed in partnership with our Solutions team, the framework is based on the premise that in the long run, expected returns should converge to some equilibrium level, while in the medium term we anticipate returns to deviate from equilibrium assumptions as a function of market valuations.

The framework also acknowledges the uncertainty inherent in making forecasts by including two measures – parameter uncertainty and realised return uncertainty – around its median return estimates.

Long-term equilibrium returns

Our starting point for estimating expected future returns is broadly based on the Capital Asset Pricing Model (CAPM).

We derive initial return estimates for different asset classes by estimating the marginal contribution of each asset class to the risk of a global diversified multi-asset portfolio. This assesses the sensitivity of each asset class to changes in the value of the global market portfolio but (in a deviation from CAPM) gives a higher weight to downside scenarios. This gives an estimate of the relative riskiness – and from this the relative return expectations – of each asset class. Into this we incorporate our estimate of the long-term forward-looking equity risk premium, currently in the region of 3.5-4.0% per annum.

Quantitative and qualitative adjustments are then made to address some of the shortcomings of CAPM. These adjustments are estimated from a range of analyses, including quantitative multi-factor decompositions of risk drivers, academic studies and economic rationale, such as rewards for illiquidity.

We are also careful in applying the model to bonds, and override it in some cases. For example, for investment grade credit, expected long-term excess returns are based on long-term average spread levels less an allowance for losses from downgrades and defaults.

Valuation-based deviations

Over shorter horizons we can expect some deviation from equilibrium, and therefore adjust our long-term expectations using measures of ‘bottom-up’ asset market returns. The metrics used vary by asset class, but all reflect an element of current market pricing, whether that be nominal bond yields, credit spreads or dividend yields.

It is worth noting, however, that while current market conditions influence our valuation-based expected returns, in practice our broader dynamic processes take into account other factors to determine the likelihood and time horizon of mean reversion to any ‘fair value’.

Parameter uncertainty

Understanding uncertainty is critical to making good investment decisions. Any forward-looking return assumption is really a point estimate, a central point within a distribution of possible outcomes. But even that distribution can paint a misleading picture of the risk of long-term outcomes, and ignore the risk that the assumptions made are incorrect.

By also incorporating parameter uncertainty in our framework, we can take a more honest and realistic snapshot of the future.

How we use CAMERA

Equilibrium returns are an essential ingredient in our strategic asset allocation process, and – alongside other characteristics – help to determine how much of each asset class is held in a fund.

The valuation measures that guide the medium-term deviations shown in CAMERA are used in a number of ways in our investment process. They can be thought of as one lens of many through which we form our tactical and medium-term views.

Going forward, we will be including a quarterly update of the framework in this publication, and highlighting any notable changes in either medium- or long-term assumptions. For more detail on the overall framework, please speak to your LGIM representative.




The above is an extract from our Q1 Asset Allocation outlook.

Tim Armitage

Quantitative Strategist

Tim is a former musician reincarnated as a quantitative strategist, and subsequently spends more time writing code than songs these days. When not thinking about swaption strategies and risk indicators, you’ll find him running marathons, and secretly hoping there’s a day his three sons form a band that becomes the next Kings of Leon.

Tim Armitage

Martin Dietz

Head of Diversified Strategies

Who is Martin? The phrase “The power of German engineering” comes to mind. His focused work ethic on managing investments has earned him a spot on the Financial News’ 40 under 40 rising stars and his funds have received numerous awards. The only other thing Martin wants to share is that he has a PhD (summa cum laude).

Martin Dietz